Tuesday, March 31, 2009

Last week Zero Hedge posted the most recent (Q4 2008) report from the Office of the Comptroller of the Currency, which among other things, discussed the $9.2 billion bank trading loss in cash and derivatives in Q4. That itself was not news to anyone who follows the major commercial banks' operations, however should make for an interesting contrast when the OCC reports Q1 results, especially in the context of the plausible scenario that AIG may have contributed for massive derivative profits, especially for the big banks.

Now focusing on the other things side of the equation, there were several charts in the OCC report that caught my eye. The first relevant item is the insane propagation of derivative contracts over the past 10 years, not merely CDS, which those foaming in the mouth claim is the sign of the beast.

A little background: the OCC has five categories of derivative products: 1) interest rate , 2) foreign exchange, 3) equities, 4) commodities and, of course, 5) credit default swaps. And, yes, while CDS have grown as holdings by commercial banks from $144 billion in 1998 to $15.9 trillion in 2008, it is not this that is of interest. More notable, while the total derivatives basket has grown at an astounding rate, from $33 trillion to over $200 trillion over the same period, it is the interest rate (specifically swaps but also futures and forwards) category that is the biggest culprit here: growing from $24.8 trillion to $164.4 trillion! This represents over 80% of the total underlying derivative notional currently in existence according to the OCC (and about 10x Obama's optimistic projections for U.S. GDP).

Focusing a little more on the Interest Rate derivative category, the two critical subcategories here are the Interest Rate swaps maturing in under a year, and the IR swaps with a 1-to-5 year duration.

So what are interest rate swaps: in their simplest definition, they are merely contracts exchanging a stream of interest payments for another party's stream of cash flows. Interest rate swaps are often used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. The underlying key variable is, as the name implies, the interest rate, which derives from the Fed's policy decisions and subsequent spillovers into monetary markets. As interest rates fluctuate substantially less than corporate (and even sovereign) credit risk, and, one may argue, have better predictive visibility, the notional outstanding is so staggering. Specifically (and this is an oversimplification) to generate profits on a, i.e., 0.25% move in rates, the notional outstanding has to be a huge amount.

In a hypothetical example, imaginary company PIMROCK may purchase $100 billion in 30 year treasuries at price X after having a strong gut feeling interest rates may decline (or anticipate an administration pursuing outright Quantitative Easing, meaning open market purchases of Treasuries as they are printed by and through the government itself - for those confused by this circular process, please... you are not alone...). Now this is a cash purchase, and can only be executed by those that have $100 billion in cash lying around (either from investors or via repos lent conveniently by this very same administration). If you are a consumer bank, and find all your cash recently disappeared, after paying the last ever cash bonuses you could sneak by before getting stuck with 95% stock bonuses with 100 year cliff vesting, you can replicate this using interest rate derivatives, where you can use your lovely toxic assets (which are prudently marked at par, thus giving you full collateral marginability) and purchase interest rate futures and swaps, replicating this exact formulation however without single dollar exchanging hands.

This is, of course a simplistic example, and I recommend reading up on literature discussing the finer nuances of IR swaps and futures. But the mechanics of the transaction are not all that critical. What, however, is, is the amount of capital a bank pledges in order to execute these IR swaps. Now, conventional wisdom is that Interest Rate swaps are low volatility, low risk instruments. Well, amusingly when AIG CDS was trading at 15 bps over LIBOR, people were saying the same about Credit Default Swaps.

And this is where a chart in the OCC report really sticks out: one which talks about Total Credit Exposure (TCE) to Risk Based Capital (RBC).

But first a brief definition of TCE for the wonkish: TCE is the sum of Net Current Credit Exposure (NCCE) and Potential Future Exposure (PFE). For a portfolio of derivative contracts, NCCE is the gross positive fair value of contracts less the dollar amount of netting benefits. On any individual contract, current credit exposure (CCE) is the fair value of the contract if positive, and zero when the fair value is negative or zero. NCCE is also the net amount owed to (from) banks if all contracts were immediately liquidated. As for PFE, Potential Future Exposure is an estimate of what the current credit exposure (CCE) could be over time, based upon a supervisory formula in the agencies’ risk-based capital rules. PFE is generally determined by multiplying the notional amount of the contract by a credit conversion factor that is based upon the underlying market factor (e.g., interest rates, commodity prices, equity prices, etc.) and the contract’s remaining maturity. However, the risk-based capital rules permit banks to adjust the formulaic PFE measure by the “net to gross ratio,” which proxies the risk-reduction benefits attributable to a valid bilateral netting contract.

In a simplified nutshell, TCE is total max pain in case the proverbial feces hit the fan. Now, as the metric is a ratio to Risk Based Capital (which is simply the sum of recently infamous Tier 1 and Tier 2 capital), the higher the metric, the scarier things may get, as in another "highly improbable" 6 sigma day, when the impossible becomes mundane, banks may have to demonstrate "they are good" for their collateral. In very much the same way Basel I required banks to have capital ratios of 4% for Tier 1 and 8% for Tier 2, the RBC is a cushion that could take the first loss chunk on that elusive feces-hitting-fan day.

The OCC discloses the TCE/RBC ratio for the top five banks, and one name in particular jumps out.

Yep, Goldman Sachs... Looks like Blankfein's minions went from a TCE/RBC ratio of 4% to 1,056% in the span of one quarter! In fact, Goldman is so enamored with Interest Rate Swaps that it has almost the same notional outstanding as Bank of America, and more than Citigroup.

The thing to note, is that unlike both Citi and BofA, which actually are real consumer banks with a depositor base, Goldman is a consumer bank only in name (when is the last time you deposited your cash in a Goldman retail branch?). Consequently, BOA and C have total assets of $1.5 trillion and $1.2 trillion, both more than 10x the assets of GS, which is at $162 billion (and this excludes the incremental assets at the Bank Holding Company level for both BOA and C).

Has Goldman, in its pursuit to catch up with the imaginary PIMROCK decided to chew off a little more than its assets would allow? 1,056% more in fact? Or, alternatively, has the company bet a little too much in its bet that it can easily anticipate interest rate moves? As pointed out, over $160 trillion in Interest Rate contracts exist currently. What the credit crunch taught us is that the risk management of credit derivatives was woefully inadequate in a time when credit was flowing freely and the system was nice and liquid. After the bubble burst, certain entities (wink wink AIG) ended up having to commit capital to a sizable amount, more than half at times, of the total notional of derivatives the company had underwritten - a scenario previously never thought possible. And the massive reduction in global CDS notional outstanding over the past year and a half (from over $60 trillion to under $30 trillion today) has been a direct result of financial companies realizing they did not provision well enough for the "black swan" day, and thus rushing to unwind as much of these ticking time bombs as they could.

In the meantime, the interest rate black swan is growing. Do not misunderstand us: Zero Hedge has no idea what, if any, a black swan in Interest Rates may be. It is - by definition - an unexpected, unpredictable, outlier, aka fat-tail, event. Its prediction would immediately render it a grey swan at best, if not beige. However, instead of focusing so much on CDS as the financial system bogeyman, is it not time to look at some of these other derivative instruments that may soon plague the Basel I/II and whatever other risk consortia appear in the future. At $200 trillion in total derivatives, and $160+ trillion plus concentrated in Interest Rates, a fat tail event here, whether due to a paradigm shift in US monetary policy (that whole thing about Greenspan focusing on inflation instead of deflation now might raise a few eyebrows), or something totally different, even partial needs to satisfy these contracts will result in staggering and unmanageable repercussions to the global economy (tangentially, is it even physically possible to print $200 trillion in one year?)

Of course, as everything is smooth sailing in IR Swaps for now, I doubt anyone will even think about potential issues in this space... until it is too late.

MR. COHN: Peter makes the point that if you don't have the bond, you shouldn't be able to trade the CDS. If you have the bond and you don't like the credit, it's really easy: sell the bond. The CDS market really is needed for people that don't have the bond but have the credit exposure. So if you're a trade creditor, and you've got big obligations to a company and you want to make sure you're going to get paid, that's when you need the CDS market, you need to hedge yourself.

http://online.wsj.com/article/SB123835920915467021.html

can you believe these guys hedge themselves! theres gotta be a black swan in there somewhere.

Or it's because they used to only have a very small portion of their business that counted as a commercial bank, but as of 4Q08 the entire firm does.

I'm highly confident that GS hasn't changed their derivatives positions by anything like the magnitude this chart suggests, and equally confident that it's the fact they only BECAME a commercial bank a few months ago that creates the unusual chart.

Or it's because they used to only have a very small portion of their business that counted as a commercial bank, but as of 4Q08 the entire firm does.

I'm highly confident that GS hasn't changed their derivatives positions by anything like the magnitude this chart suggests, and equally confident that it's the fact they only BECAME a commercial bank a few months ago that creates the unusual chart.

Can't tell from data on the post but is it possible this is an overstatement similar to gross notional on CDS? Some traders that pay fixed to hedge and instead of doing a tear-up/unwind and get ripped off by another dealer will recieved fixed instead. Does the data include caps, floors, swaptions, etc that have limited loss in a blackswan type event?

Any bank like goldman that makes markets in IRS, does corporate bond u/w (hedge deals in swaps market prior to launch), holds mortgage and ABS bonds, and lending for sale (securitization) will be running a fairly large IRS book and it would be irresponible if you didn't. Further since a fair amount of these products have durs/WAL 10yrs and in, they will tend hedge in the short end of the curve.

Of course it is GS so they are also probably making large leveraged rate bets. More interesting would be which way are they leaning? Looking for some type of failed auction and rates explode to upside (some 1 or 2yr into 10 or 30 swaption gives nice lev for this trade) or looking for Japan style long low rate period? That will tell you what event blows them up. If you really want to extend your conspiracy theory, one of the biggest users of IRS is FNM/FRE so could that be another govy transfer to banks?

If there is one thing that the US government controls with an iron fist, it's interest rates. They may end up creating 1000% inflation, but I'm guessing Bernanke was good for his word; interest rates will remain low for a substantial period of time. That includes both the short and long ends of the curve. With the likes of GS on the hook, do you really have any doubts.

so what about that not-exactly-a-rounding-error 20 trillion in wealth that was vaporized in the past two years from housing alone...how exactly does that factor into your 1000% inflation scenario?

Oh, and the securitization market that, for all intents and purposes, is at zero issuance...esp. considering that it accounted for 50% of the worlds financing for the last 10 years? Where do you put that in your 1000% inflation model?

"so what about that not-exactly-a-rounding-error 20 trillion in wealth that was vaporized in the past two years from housing alone...how exactly does that factor into your 1000% inflation scenario? "

Did you read my entire post, or just that one sentence? What I said was, that if the Fed is indifferent to the inflationary impact they can fix interest rates anywhere they please, for as long as they please, under any set of economic circumstances. Under Tyler's black swan scenario, such a manipulation (i.e. buying treasuries with printed money in an inflationary environment) would result in hyperinflation. Please try to read with comprehension.

S'okay. Sometimes my internet posts aren't as explicit as they could be, in the interest of saving time. In this case, I assumed that the fat tail Tyler was referencing was renewed inflation and suddenly rising interest rates, which obviously may or may not happen in the real world. I didn't say that in my first post.

This comment ties in to the "AIG was responsible for..."posted Sunday too.

Its Feb '94 and GS nearly blew up because a prop desk in London, across multiple asset classes was essentially positioned the same way. Gavin Davies assured GS clients and dealers alike the FED would do nothing...Over $500m loss later and by September Summitomo & Bishops Estate(Hawaii) join the GS family, recapitalising the partnership.GS swears never will a group of traders be allowed to sit together, or trade together.Risk is the new metric.

In '98 just after leading a Russian Bond issue, Michael of Sherwood's desk famously short the very issue ahead of the settlement period, making a huge wedge of dough. During this period Russia defaults and suddenly the previous years Asian crisis looks like a dress rehearsal. But we're making loads of money. Minor problem is on same floor a month later the Swaps group run by Goldenballs have been putting on the same trade that is bringing the world to a near meltdown...The LTCM arbitrage is famously being replicated at a number of prop desks around the street. Its just Merriwether & his Nobel laureates were the first to blink. So the swaps group,who sit on the 2nd floor at PBC in London, segregated away in their own area have just put on huge risk that has resulted in over $900m being lost.Yep,they're sat together and given way too much rope...again.

Its OK...because we have a friend on the inside.Bob Rubin is Billys Treasury secretary, and Corzine is parachuted in with a team of traders from around the industry(mostly GS)into LTCM. Within a year a crisis is averted(GS and the other banks made out very well). For the 2nd time Corzine would come to the rescue(the first was only a couple of years before when a trader in Pearl St blew up over a$100m).

Remember Abby Cohen and her NASDAQ forever, well they lost money in 2001 too.

Check out GSs exposure to property through the Whitehall enterprises... Today they have shown through AIG CDS counterparty calls, getting treasury funds at a rate many times better then a similar stake got Warren Buffet, that surely the business is being stretched?

Lets face it, what kind of half-wit (Viniar)says in late summer 2007 following chunky losses at the wonderfully original Alpha fund..."that we have seen events 25standard deviations away from what we know". True, if your input data is massaged to suit your purposes, BUT not if you factor in a liquidity premium into every asset. By the way Iwanowski & carhart finally resigned today from their charade.

With the sort of leverage being used by these geniuses nothing that subsequently happens should be called a black swan any more than an explosion resulting from smoking crack in a dynamite factory could be called one.

When Lehman went down, I know that Goldman filled the void in the Catastrophe Bond market. They are the new total return swap counterparty to State Farm on their rather tremulous Merna Re Bond.

So I don't see that it has to be a directional bet, so much as filling the void left by Lehman: of course with very little capital.

A lot of these swaps would guarantee a fixed return against the underlying variable income stream. In which case you want the variable income to remain high. But presumable it would not be impossible to buy an inverse hedge against the income stream using the cost differential plus a lot of leverage to may the whole transaction a mathematical lock.

The obvious big problem would be counter party default. If AIG is the counter party to one side of a lot of these swaps you have real problem. Your swap arbitrage very quickly becomes a one way high leverage bet.

As someone else already said, the only reason for the spike is that GS just became a bank. They have been doing IR derivatives for years and years and definately did not just invent them.

Looking at just the total notional exposure without netting does not give any insight to actual risk exposures. As interest rate derivatives are linked in large part only to a few underlyings (3m libors in different currencies) they are easily nettable, as can be seen by the results of for instance the Trioptima netting actions (http://www.trioptima.com/media/press_releases/090324_trioptima_compresses_327_trillion_usd_irs_in_larges.html).

Real interesting would be the net risk against basis. Al lot of things in the past considered similar are found out to be pretty different, like 1m and 3m libor. Consequently these basis trades have blown up, similar in what happens accross currencies. (USD-JPY basis in 5y for instance was always in 10bp range but moved in 100 bp range this year).

Another reason for the increase in total notional of IRS will have been exactly the volatility of lately. VAR and stress test and other risk measures will make desk reduces their net interest exposures and therefore they have to enter into opposite swaps to close out positions. Not increasing risk but reducing risk.